Splitting Headaches

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“We were not designed or structured to be the most important company in the entire financial system,” said Jay Brown on February 19th as he returned to MBIA, charged with steadying the company he had run from 1999 to 2004.

You may think otherwise, given the markets’ fevered concern over the “monoline” bond insurers. Thanks to unwise forays into mortgage-backed securities, an industry that a year ago was basking in profitable obscurity now stands accused of endangering large chunks of the financial system, including Wall Street banks and the huge market for municipal bonds. With rating agencies preparing to downgrade them to levels that could destroy their business, and regulators pushing for bail-outs or break-ups, the monolines’ moment of truth has arrived. For anyone linked to the $2.4 trillion of securities they have guaranteed, it is nail-biting stuff.

The sense of urgency has increased since Eric Dinallo, the insurance regulator for New York state, stepped up pressure on banks to offer help. At a congressional hearing on February 14th, Eliot Spitzer, New York’s governor, gave the insurers a few days to strike rescue deals or face government intervention—meaning, probably, forced break-up into good books (the original “monoline” business of backing municipal bonds) and bad ones (collateralised-debt obligations and the like).

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Though no agreement had been reached as The Economist went to press, the industry had begun to embrace radical change. FGIC, the fourth-largest monoline, filed an application to split itself in two. Ambac, the second-largest, began work on plans to raise $2 billion in capital as a possible prelude to a break-up. And the rehiring of Mr Brown was seen as a sign that MBIA, too, is thinking the unthinkable.

Some see this as a negotiating ploy. The monolines know that, by threatening to break apart, they may force Wall Street banks to stump up the cash to keep them whole. The banks fear that stand-alone structured-product insurers, cut off from the municipal bit, could not pay all of their claims. This would drag down the value of securities the monolines have guaranteed and increase the banks’ write-downs.

Some also worry that these weakened monolines would be less able to honour credit-default swaps (CDS) they had sold to the banks. Meanwhile, those using CDS to bet on defaults of the monolines themselves are not sure which part of the insurer would be covered in the contract. Years of litigation could follow a break-up.

Calculating the banks’ potential monoline-related losses is more art than science, and estimates range from $7 billion to ten times that. A new report by Moody’s puts the CDS exposure alone at $120 billion for a group of 20 large banks. In the event of monoline downgrades, the banks may have to raise their counterparty reserves by a combined $7 billion-10 billion, reckons the rating agency, rising to $20 billion-30 billion if the value of hedged securities falls far. Spread around perhaps two dozen lenders, that number, though big, does not look terrifying.

The regulator and governor are shedding no tears over lenders’ losses. Their primary concern is the $2.6 trillion, tax-exempt municipal-bond market, used by cities, universities and the like to raise long-term funds, much of it from individuals. Were the monolines to lose their top-notch ratings, they fear, many issuers could struggle to meet higher funding costs.

Municipal borrowers are already being affected by the lack of confidence in the insurers. Overall issuance was 38% lower in January than the year before—though other factors, such as the economic slowdown, were also to blame.

Worse, two little-noticed but important bits of the market have imploded this month, and there are fears for a third, known as closed-end municipal-bond funds. In the first, vehicles sponsored by banks raise short-term money by issuing “tender option bonds” (TOBs), then use it to invest in longer-term municipal bonds and the like. Buyers have fled these programmes, in part because of worries over muni-bond insurance. The banks behind TOBs are having to buy up the unsold bonds, further straining their balance sheets—though losses should be manageable as the bonds are high-quality.

Problems in “auction-rate” securities are causing even more alarm. In this $330 billion market, long-term bonds are, in effect, transformed into short-term ones by having the interest rate reset in auctions every week or month. The allure for issuers, including hundreds of municipal bodies, is lower interest rates than typical long-term bonds, and the ease of paying down debt if they build up a surplus, by simply taking part in the auction themselves.

This month, however, dozens of auctions have failed as investors have questioned the quality of the assets on offer. Tens of billions of dollars of bonds went unsold last week. Dealers, such as Citigroup and Goldman Sachs, have backed away from soaking up unwanted paper. This has come as a shock to corporate treasurers at firms like Bristol Myers Squibb and US Airways, who piled into auction-rate debt assuming it to be safe.

Because the interest rate automatically clicks up if the auction is a dud, hospitals, museums, universities and ports have suddenly found their debt-service bills rising sharply. New York state entities’ weekly borrowing costs have climbed by more than $2m, for instance. Some rates soared to 20%—though later they fell back to a still high 8%. Issuers are scrambling to refinance into proper long-term bonds, or asking banks for letters of credit. The Treasury has even offered to make it easier for issuers to convert to other types of debt.

Auction-rate bonds may never recover. That would not be catastrophic. They are extra gears, engineered by over-achieving bankers, rather than essential market cogs. May the same be true of bond insurance? The crisis shows it is only as good as its underwriters, and they have proved inept. Moreover, muni bonds are rated using tougher criteria than corporate bonds. If they were not, most would be almost AAA, reducing the need for insurance.

The more pressing question is whether the government should intervene in any other way than encouraging talks. There are grounds for scepticism. As painful as the disruption in municipal markets is, it looks temporary. Rates fell this week, and high-quality issuers were able to raise finance in municipal-bond markets.

Moreover, there is no supply crisis in the monoline business: Warren Buffett has entered the market (even offering to take on rivals’ municipal businesses) and some less-troubled monolines, such as FSA, are grabbing market share. The monolines’ woes are already largely priced in. There is scant evidence that leaving their fate to market forces, though it may be painful, would bring down Wall Street banks. If the banks see the danger growing, they will have even more incentive to find the money to help.

On top of which, a state-mandated break-up could trigger a wave of lawsuits, further eroding trust in the system. Eager as they are to be seen doing the right thing, Messrs Dinallo and Spitzer should wait to see graver danger than this before they meddle in private contracts.